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Why Have Inflation Forecasts Been So Wrong?

To explain why forecasters at the US Federal Reserve and other major institutions missed the mark on inflation in recent years, it is tempting to conclude that they were blindsided by unpredictably large shocks. But if the prevailing models work only when variables are relatively stable, they are of little use.

NEW YORK – Last year, following the Great Inflation of 2021-22, central banks, leading academics, and international institutions issued a smattering of post-mortems. Yet even before the ink was dry on their analyses, inflation forecasts were being revised down almost as fast as they had been revised up during the two preceding years.

For example, in June 2023, the US Federal Reserve’s median projection for core year-on-year personal-consumption-expenditures inflation (excluding food and energy prices) in the fourth quarter was 3.9%, with the Federal Open Market Committee’s projections ranging from 3.6% to 4.5%. In the event, it was 3.2%.

Before addressing what forecasters are missing, two clarifications are in order. First, central banks’ inflation forecasts are no worse, and may be somewhat better, than private-sector forecasts, on average – which is what one would expect, given that they tend to have better access to data and more expertise. Second, inflation forecasts have not obviously gotten worse. Yes, the International Monetary Fund, among others, has noted that inflation forecast errors were 2.5 and five times larger for 2021 and 2022, respectively, than the average for 2010-19. But the levels of annual inflation in 2021 and 2022 were 1.3 and 2.5 times larger than the 2010-19 average, and the changes in annual inflation rates were 2.6 and 7.1 times larger.